Fixing fixed income : Brett Chappell 

Voice trading is going to be a thing of the past. There will be consolidation on the sell-side. The buy-side needs to learn how to aggregate data and above all how to aggregate liquidity. Attitudes and behaviour will have to change, and the buy-side will have to open up more. These are the conclusions reached by Brett Chappell, head of fixed income trading at Nordea Asset Management.

“There is liquidity despite what everyone says, but there can be a steep cost,” Chappell told the Buy-side Perspectives. “Liquidity is fragmented if you don’t know where and how to look. We pull data from various sources to see where to go and whom to approach. A good EMS is essential to assimilate all this information into one place so our screens don’t look like a work by Jackson Pollock.”

The decline of liquidity in fixed income is well-documented. In essence, the sell-side is both less able and less willing to intermediate risk, due to a combination of regulatory pressures and the higher costs that have been introduced by reforms intended to prevent a rerun of the financial crisis.

Part of the solution may be the rise of new electronic trading platforms in fixed income. For Nordea, these platforms include venues such as Project Neptune, B2Scan, Honeycomb and Bloomberg, as well as Liquidnet and TradingScreen, both of which have fixed income offerings. According to Chappell, these venues are increasingly becoming a first port of call rather than the sell-side. However, he still believes that buy-side to buy-side pool initiatives are not a replacement for the banks but rather a supplement to them. “We still need their research, the primary, their services etc. But when the liquidity is not there, we need to seek alternative liquidity channels,” he said.

For the newer platforms, those willing to go the extra mile on corporate governance may gain the upper hand. Like other buy-side institutions, Nordea places a high value on systems that can’t be gamed by unscrupulous players in the market. There is also a sense that some of the newer platforms may be tailored more to the second and third tier, while in other parts of the market new brokers may emerge focused on niche segments. But for Nordea, one of the important factors is how any new platform can interact with the firm’s OMS.

While in some areas such as equities, market players are talking about the empowerment of the buy-side, in fixed income there is a limit to how far that can go. According to Chappell, the buy-side can certainly engage with other players in the market more often – but the buy-side is not in a position to take over all the duties of the sell-side.

“If there’s a very illiquid bond, it doesn’t hurt to reach out to other asset managers to ask who is good at this,” he said. “This is a relationship question, not an agency broking model. We do not have the mandate to replicate a bank’s business model, nor do we wish to do so. We are here to help our investors generate alpha.”

One of the major factors behind change in the fixed income market, as with other asset classes, is regulation. There are multiple regulatory initiatives that impact Nordea and other buy-side firms in the fixed income space; these include the European Commission’s MiFID II directive, as well as its CSDR legislation, which aims to harmonise the rules and supervision for Europe’s central securities depositories. Then there are the different regulators at a national level – Nordea interacts with four in the Nordic region alone. The different standards arising from these differences are a significant source of cost for the business – and even moves to standardisation are not always positive.

“CSDR will be problematic, especially for high yield bonds in the credit space,” said Chappell. “If there’s a forced buy-in after two days it really wouldn’t make sense for certain house to continue quoting two-ways. Sell-side traders will be more reticent quoting the right side.”  

Perhaps more worrying for the institutional investor are MiFID II requirements around transparency. European regulators have expanded the basic structure of the original MiFID to encompass other asset classes, including fixed income and FX. While these measures are in principle intended to safeguard the market, there are serious concerns among multiple players on the buy-side that too much transparency may not be beneficial when applied to asset classes less liquid than the equities for which those principles were originally meant.

“Transparency is not necessarily appropriate pre-trade,” said Chappell. “It makes sense for private banking but for institutional investors we have to be careful. The problem is if I am trying to work under the radar and sell a larger quantity of illiquid instruments, I’m concerned that nothing can stop a hedge fund seeing that and going short. Clever people will try to find ways to game the system. The illiquid / Large in Scale waiver programs make sense in terms of post-trade transparency. Predatory traders can create programs which cross reference an investment managers’ publicly listed holdings with post-trade data on an instrument by instrument basis.”

As is the case in other asset classes, it can seem as though unintended consequences can be taken as a given when it comes to regulation. One of the other factors of potential concern to the buy-side is that due to new regulatory standards around due diligence, the onboarding of new brokers can be a challenge. This has led some participants on the buy-side to be more careful about their broker relationships.

“You don’t want to spend six months on-boarding a new broker only to find out that they’re quitting activity in that asset class,” said Chappell. “The same can be said for going through the hoops for many of these new platforms- it requires a lot of effort from several stakeholders, and given the man hours put in, it would be a colossal waste of time if the new entrant went belly up due to lack of deep pockets.”

On the other side, the rising regulatory pressure is also causing the sell-side to re-assess its relationships with the buy-side. One potential pitfall of this is that there could be an increasing bifurcation in the services offered by the sell-side, with the best services going to the top tier buy-side houses, with the rest of the market receiving less dedicated support. For example, tier two or three firms may find themselves forced to make do with one sales representative from the sell-side, where once there were five. Nordea estimates that such a process will mostly likely push the second and third tier firms towards transacting more digitally, on more dedicated platforms.

“By 2020, we will see the majority of trades, even voice trades, being carried out electronically,” said Chappell. “A voice trade is going to be a thing of the past. We may see social networking applications superimposed over more traditional trading tools. Chat systems have replaced the message function in just a few short years. The status quo ante will no longer be viable.”

One subset of tools that will remain key to best execution in fixed income is TCA. For the buy-side, there are two basic options: either to build a system in-house, such as the system built by AXA Investment Managers, or to buy from an outside vendor. One of the potential advantages of a vendor is that they can be neutral towards the buy-side firm’s customers. At time of going to press, Nordea is currently reviewing its options for TCA, including meetings with TCA providers.

“TCA is a subset of best execution,” said Chappell. “It can quantify alpha generation by the trading desks as well as allowing a manager to ascertain trading staff’s patterns and behaviour. There is no standard setup for fixed income, and there will be an even more pressing need for best ex documentation in the run up to MiFID II in January, 2018.  Fixed income desks need to ascertain what they need first, align these criteria with the trading and investment styles, and then look at TCA as a natural evolution. Only at this point does it make sense to approach a service provider by laying out your specific needs, rather than panicking and buying an off the shelf  product. To further complicate matters, there is no benchmark for the providers’ annual subscription fees. We have been going through the beauty parade for fixed income TCA providers and the prices proposed are all over the shop.”

Despite the ongoing electrification of the fixed income markets, there are limits. While execution algorithms have made strides forward in other asset classes such as equities and FX, not everyone is yet convinced of their value in fixed income. “Algo trading is possible, but given our active investment style, liquidity, and counterparty constraints, it is not currently feasible for us. Much of what we do is still very high touch,” said Chappell. 

"There is liquidity despite what everyone says, but there can be a steep cost. Liquidity is fragmented if you don't know where and how to look."

"A voice trade is going to be a thing of the past. The status quo ante will no longer be viable."

Elliott Holley
Head of Global Buy-side Research
eholley@kandkgc.com
+44(0)7759 476779